UK equity risk: decoding FTSE 100 defensive tactics

• UK equities face increasing headwinds and investors are concerned about potential index volatility.
• This blog discusses two defensive versions of the FTSE 100 designed to reduce index risk: the FTSE 100 Target Volatility index and the FTSE 100 Minimum Variance index.
• The FTSE 100 Target Volatility index aims to maintain a specified level of index volatility by adjusting exposure to equities and cash.

As the UK share market shows signs of weakness, we look at two different index strategies to help reduce equity risk. Indices that aim to minimise risk or manage volatility can help investors who wish to adopt a more defensive stance.

Since early 2023, UK equities have run out of steam. Having topped 8,000 in February, by early October the FTSE 100 of UK large-cap stocks was back below 7,500.

After 14 consecutive interest rate rises in the UK, many investors are concerned about the effect of a possible recession on their shareholdings. In particular, they may be concerned about higher levels of index volatility, especially after a relatively quiet couple of years.

Two versions of the FTSE 100 have been designed to help reduce index risk, although they achieve this goal in quite different ways. They are: 

• The FTSE 100 Target Volatility index
• The FTSE 100 Minimum Variance index

In this blog, we focus on the FTSE 100 Target Volatility index. In a second, accompanying blog, we explore the FTSE 100 Minimum Variance index in more detail.

As its name suggests, a target volatility index aims to achieve a pre-specified level of index volatility.

It does this by varying the index’s exposure to the underlying market (or market segment) through different combinations of equities and cash. The target volatility index’s exposure to equities is referred to as the leverage factor and it can exceed or fall short of 100%. The index methodology can embed caps and floors to limit the leverage level.

If the volatility of the underlying equity market is lower than the pre-specified target, the target volatility index increases its allocation to the equity market (to above 100%) and borrows cash to do so. 

If the opposite occurs and the volatility of the underlying equity market is above the pre-specified target, the target volatility index cuts its equity exposure to below 100% and it allocates the remaining assets to cash.

[As a reminder, an index is a theoretical representation of markets, and it doesn’t actually own or invest in anything. Nevertheless, we often use ‘index’ as a mental shortcut for a portfolio tracking the index.]

Let’s assume the FTSE 100 is the underlying equity market and we wish to set a volatility target of 15%.

First, we measure the historic volatility of the FTSE 100. In this blog, we measure the FTSE 100 index’s volatility over the previous sixty trading days, expressed as an annual figure, but we can use different lookback periods for the volatility calculation.

We then take that result and use it as the input to the target volatility index’s exposure calculation. If the FTSE 100 index’s trailing sixty-day volatility is above 15%, the equity exposure of the target volatility index will be below 100%.

Let’s rewind to the outbreak of the coronavirus pandemic, which caused a sharp sell-off in equity markets. The trailing sixty-day volatility of the FTSE 100 at the beginning of Q2 2020 was nearly 30%, well above the desired level of 15%.

During that quarter the target volatility index cut its exposure to the FTSE 100 to below 100%, allocating the rest of its exposure to cash.

A year later, equity markets had rallied substantially and market risk had dropped in tandem.

Between Q2 and Q4 2021 the sixty-day trailing volatility of the FTSE 100 fell below the 15% target and even reached single figures. During this period, the target volatility index leveraged its exposure to equities to above 100%.

In other words, since the target volatility index aims for steady volatility, it either reduces or increases the riskiness of the underlying equity index.

In the chart, we show by how much it did so over the two-year period immediately following the outbreak of coronavirus.

At the beginning of H2 2020, when the FTSE 100 index’s sixty-day trailing volatility was nearly 30% (see the first chart), the target volatility index reduced it by nearly 20% in absolute terms (see the second chart).

By contrast, in late 2021 the FTSE 100 index’s sixty-day trailing volatility was in single figures. So the target volatility index had to leverage its exposure to the FTSE 100 to reach its 15% target.

Although the target volatility index doesn’t hit its 15% goal precisely, it’s there or thereabouts. It clearly works to smooth the risk of the underlying index. But what about the effect on returns?

In the table we show the return, volatility and return/volatility ratio of the FTSE 100 and its target volatility index over 1,3, 5, 10 years and the two-year post-Covid period (from Q2 2020 to Q1 2022, inclusive), as well as the quarterly returns for that two-year period. All return and volatility figures are annualised.

A few things are worth noticing:

• Over time, the target volatility index did its job of keeping index volatility close to 15% (see the cells highlighted in bold in the “volatility” table), while the FTSE 100 tended to have higher volatility.
• When the FTSE 100 fell with relatively high volatility (in Q3 2020), the target volatility index outperformed because it had less than 100% equity exposure (see the cells in bold in the “return” table).
• When the FTSE 100 rose with relatively low volatility (Q2-Q4 2021, “return” table, cells in bold), the target volatility index outperformed because it was leveraged (it had more than 100% exposure to the underlying index).
• In general, the return/volatility ratio of the two indices was fairly stable over different time periods—an unsurprising result, since the more equity risk you take on, the higher the return you’d expect.

Source FTSE Russell. 

All this suggests that a target volatility index might suit investors who are looking to dial down equity risk but keep some exposure to potential upside.

The target volatility approach is only one way of trying to reduce equity index risk. In our second blog, we look at an index approach with a similar goal but a very different way of achieving it—minimum variance.